Question

What does it mean to "Provide Liquidity"? More specifically what does it mean to provide liquidity to a market? Please also explain how banks provide liquidity and why this is important?

Answer 1

In simpler terms, liquidity in the market refers to the ability of a market, like stock market, real estate market or money market to convert the assets that trades within it into cash easily. Here liquid means cash. Cash is a universally traded asset and therefore is considered as the most liquid asset. Therefore, providing liquidity means providing cash to the market. Banks have the ability to provide necessary liquidity to money market, stock market etc. They have indirect control over the liquidity situation in these markets. If in a market a asset can be easily traded and converted into cash, without affecting the price of the asset too much, then the market is said to be liquid enough. The most liquid market in practicality is Equity market, because, here shares can be sold and converted into cash within few hours.

Banks provide liquidity to the markets by lending money to businesses and individuals, making purchases of securities in the market by themselves etc. However, if the FED decides to reduce the level of money supply in the economy, the banks, in that case will be short of liquidity and the rate of interest will be high. In such situation, the liquidity is squeezed by the banks from the market, so that inflation can be regulated. Higher level of liquidity and easy availability of funds fuels inflation in the longer run.

Liquidity is important because, if in a market, there will be no or less liquidity, there will be less trades and turnover within the same. Low liquidity means less cash available in the economy, which means high interest rates and low investments in projects and businesses, hence lower GDP growth. Therefore, in economics every aspect is linked and a decline in any single fact can cause a start of vicious circle.