Broad Liquidity

The term broad liquidity refers to a category of the money supply which includes all funds in M3, individual holdings in accounts, savings bonds, T-bills with maturity of less than one year, commercial papers and banker's acceptances. Broad liquidity is the widest measure of money supply. It can be generalized as the total amount of money issued by a central bank, plus any new money created by commercial banks through lending. This is one of the economic measures that policy-makers and investors use to track and forecast inflation.

A financial asset is considered liquid if it can be easily redeemed for cash at short notice. The most liquid instruments in the money supply are transferable deposits and currency, because these instruments can be exchanged on command for other types of financial assets, nonfinancial assets and goods and services. The broad liquidity of an economic system is therefore considered to be the sum total of all liquid monetary assets, including cash, transferable deposits, bank notes, bonds, securities and other financial assets that can be converted to cash at short notice and with no or little loss of value. It contrasts with narrow or thin liquidity, which refers to the supply of actual, physical currency available to an economic system.

Broad liquidity influences consumer spending, price stability, investments, inflation and interest rates. This influence of broad liquidity over the economy is known as the liquidity effect. For example, if an economic system has insufficient broad liquidity, interest rates can climb, causing economic activity to slow. If there is too much broad liquidity in the economic system, the opposite can happen; interest rates can drop, causing inflation.

Higher broad liquidity can contribute to other economic effects, as well, such as the formation of economic bubbles, or rapid increases in stock or property bubbles that precede a collapse in prices and values. This happens because higher liquidity leads to lower interest rates, which makes it easier for consumers to finance purchases. However, in a recessionary economy, the Federal Reserve can take advantage of this aspect of the liquidity effect to stimulate recovery by lowering interest rates in order to encourage consumer spending. Lowered interest rates can also encourage businesses to invest in infrastructure or hiring.

The Federal Reserve can manipulate the liquidity effect by buying or selling securities, or lowering or raising interest rates, changing bank reserve requirements, although these measures often have mixed results.