If you have ever tried swimming, then you would know that it is no fun to swim in shallow waters, on the other hand, if you are a bad swimmer and go for the deep waters, you also face the risk of drowning. 

So according to your comfort level or expertise, you will always try to find the perfect zone to swim. But the catch is there is no perfect zone. Similarly, in the swimming pool of markets, there is no perfect zone available when it comes to liquidity; either too much or too little liquidity can be harmful.

Let us dive deeper into the topic and understand this phenomenon of liquidity and its effects on the economy and markets.

What exactly does liquidity mean for stock markets and the economy?

From the point of view of stock markets, liquidity ensures that it is possible to  enter or exit trades with ease and with minimal impact cost i.e buyers can find sellers easily and vice versa.

From an economic perspective, liquidity makes sure that people have enough money available with them so that they can carry on regular economic activities like buying or selling goods and services amongst themselves. 

If we go back into the past and study the financial crises of the past, we can say that liquidity is a double-edged sword and can be beneficial and harmful to an economy. Let us understand how.

What are the advantages of liquidity in the economy?

All the money which is available in an economy ultimately is made available by the central banks like RBI in India. When RBI lends money to the banks at lower interest rates, the commercial banks eventually make that money available to businesses and people, which leads to more economic activity. 

For example, if home loans are available at lower prices then people will prefer buying more homes, and the demand will increase, similarly, companies will invest in creating more assets. This eventually will lead to more consumption and boost the growth of the country. 

But over a period of time, this liquidity will reduce as money will get used up and economic activity will reduce. In such situations, the central bank will intervene and infuse more money into the system so that consumption gets boosted again. 

In India, the RBI utilizes bond buybacks and Open Market Operations to inject liquidity and offer stimuli in crises like during the covid pandemic when demand for goods and services reduced and economic activity halted, thus supporting growth and economic activity.

What are the disadvantages of high liquidity in an economy?

Liquidity comes with its ill effects, though, let us try to understand them with the same example of housing. Let us say home loans are available at very low-interest rates. This will eventually cause more people to apply for them and will create more demand for new homes than their availability.

Since more and more people have money to buy homes due to lower interest rates the prices of real estate and related industries will shoot up creating more inflation in the economy. This will eventually cause inflation to shoot up to unrealistic levels. Thus, in this case, although liquidity helped boost demand, it also created a price rise, eventually leading to inflation.

How liquidity is controlled?

Central banks intervene when this excess liquidity provided by them causes a sustained hike in inflation and leads to an economic bubble which was being pumped by the liquidity it provided in the first place. So they start hiking the interest rates and do open market operations to take away money which was initially provided to the commercial banks instead of bonds. 

Thus reducing the liquidity, leading to lower demand for loans and, subsequently lower availability of money in the economy. The reduced economic activity causes the bubble to burst and wipes out a significant amount of investments done by market participants and money becomes dearer again.


To eventually boost economic activity again when inflation has reduced to a great degree, banks are forced to infuse liquidity. Thus a cycle of growth and de-growth begins causing volatility in markets.  

Conclusion

As investors, we should be able to understand the cycles of liquidity and illiquidity in markets to judiciously allocate our money to high return-generating assets in times of high liquidity while ensuring that during times of low liquidity and economic downturn, we are invested in safer assets.  

FAQs

What does liquidity mean in the context of stock markets and the economy?

In the stock market, liquidity refers to the ease of entering or exiting trades without significantly impacting prices. From an economic standpoint, liquidity ensures people have enough money for regular activities like buying and selling goods and services.

How does liquidity impact economic activity?

Adequate liquidity promotes economic activity by enabling businesses and people to access funds easily for transactions. For instance, lower interest rates on loans can lead to increased demand for goods and services, boosting economic growth.

Can excessive liquidity have negative effects on the economy?

Yes, excessive liquidity can lead to inflation and asset price bubbles. For instance, lower interest rates might increase demand for assets like real estate, causing their prices to rise. This can eventually result in unrealistic inflation levels.

What is the impact of liquidity cycles on investors?

Investors should be aware of liquidity cycles and tailor their investment strategies accordingly. During periods of high liquidity, they can consider higher-return assets, while during low liquidity periods and economic downturns, they should focus on safer investments.