Liquidity: Definition, Ratios, and How It's Managed

How It Controls the Economy and Your Finances

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Money is like water to the life of the economy. Photo: Max Schulz/Getty Images

Liquidity is the amount of money that is readily available for investment and spending. It consists of cash, Treasury bills, notes and bonds, and any other asset that can be sold quickly. High liquidity occurs when there are a lot of these assets. Low or tight liquidity is when cash is tied up in non-liquid assets. It also occurs when interest rates are high, since that makes it expensive to take out loans.

Capital is the amount available for investment by businesses or individuals. It includes highly liquid assets like cash and credit. It also includes non-liquid assets like stocks, real estate, high-interest loans. That's because the large financial institutions that make most investments prefer using borrowed money.

Even consumers traditionally prefer credit and loans. Since the Great Recession, they've shied away from credit card debt. Instead, they use debit cards, checks, or cash to make sure they can afford their purchases. They've also taken advantage of low-interest rate loans to buy cars and get an education. It's too soon to say whether these consumer spending trends are permanent, or just a reaction to the recession.

How the Fed Manages Liquidity

The Federal Reserve manages liquidity with monetary policy. It measures liquidity with the money supply, such as M1, M2, and M3.  It guides short-term interest rates with the fed funds rate.

The Fed uses open market operations to affect long-term Treasury bond yields. It created massive amounts of liquidity with quantitative easing. The Fed injected $4 trillion into the economy by buying bank securities, such as Treasurys.

When rates are low, capital is easily available. Low rates reduce the risk of borrowing because the return only has to be higher than the interest rate.

That makes more investments look good. In this way, liquidity creates economic growth

Liquidity Glut

High liquidity means there's a lot of capital. But there can be too much of a good thing. A liquidity glut develops when there is too much capital looking for too few investments. That leads to inflation. As cheap money chases fewer and fewer profitable investments, then the prices of those assets increase. It doesn't matter whether it's houses, gold, or high-tech companies.

That leads to "irrational exuberance." Investors only think that the prices will rise. Everyone wants to buy so they don't miss out on tomorrow's profit. They create an asset bubble.

Eventually, a liquidity glut means more of this capital becomes invested in bad projects. As the ventures go defunct and don't pay out their promised return, investors are left holding worthless assets. Panic ensues, resulting in a withdrawal of investment money. Prices plummet, as investors scramble madly to sell before prices drop further. That's what happened with mortgage-backed securities during the subprime mortgage crisis. This phase of the business cycle is called an economic contraction. It usually leads to a recession.

Constrained liquidity is the opposite of a liquidity glut.

It means there isn't a lot of capital available, or that it's expensive. It's usually a result of high-interest rates. It can also happen when banks and other lenders are hesitant about making loans. Banks become risk-averse when they already have a lot of bad loans on their books. 

Liquidity Trap

A liquidity trap is when the Federal Reserve's monetary policy doesn't create more capital. It usually happens after a recession. Families and businesses are afraid to spend, no matter how much credit is available. 

Workers worry they'll lose their jobs, or they can't get decent job. They hoard their income, pay off debts, and save instead of spending. Businesses fear demand will fall off even more, so they don't hire or invest in expansion. Banks hoard cash to write down the bad loans and become even less likely to lend.

Deflation makes them, wait for prices to fall further before spending. As this vicious cycle continues spiraling downward, the economy is caught in a liquidity trap.

Market Liquidity

In investments, liquidity is how quickly an asset can be sold for cash. After the 2008 financial crisis, homeowners found out that houses had lost liquidity. That's because the home price fell below the mortgage owed. Many owners had to allow the home to foreclose, losing all their investment. During the depths of the recession, some homeowners found that they couldn't sell their home for any amount of money.

Stocks are more liquid than real estate. If a stock becomes worth less than you paid, you could deduct the loss on your taxes. Furthermore, you can always find someone to buy it, even if it's only pennies on the dollar. 

Liquidity Ratios

Businesses use liquidity ratios to measure their financial health. The three most important are:

  1. Current Ratio - the company's current assets divided by its current liabilities. It determines whether a company could pay off all its short-term debt with the money it got from selling its assets.
  2. Quick Ratio - The same as the current ratio, only using just cash, accounts receivable and stocks/bonds. The company can't include any inventory or prepaid expenses that can't be quickly sold.
  3. Cash Ratio - As the name implies, the company can only use its cash to pay off its debt. If the cash ratio is one or greater, that means the business will have no problem paying its debt, and has plenty of liquidity.