Liquidity And Its Effect On The Economy

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Liquidity / illiquidity

Liquidity is the idea to convert something into something else thus in finance, liquidity is “A measure of the ability and ease with which assets can be converted to cash.” (Federal Reserve.gov, 2014).
Cash as in paper currency is the most liquid form of asset because it hold qualities such as, it is a medium of exchange, a unit of account, portable, durable, divisible and fungible (interchangeable) (Brunner, K and Meltzer, A. [1971]. The Uses of Money). I.e. a £10 note in my wallet is valued the same as a £10 in another person’s wallet.
In practical terms a bank needs to remain liquid, otherwise it can have a huge consequence and a systemic failure may arise on the institution itself and could have a negative
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if they have no short term assets and are unable to liquidate they can then borrow from other banks which is very likely as banks usually have positive net worth but if for arguments sake borrowing from other banks was not an option due to low confidence the central banks who act as Lender of Last Resort (LOLR) would intervene by injecting cash into the effected bank so that it maintains cash flow.
Back in 2007 when the financial crisis hit, many banks were faced with liquidity crisis. This was because they had no short term assets i.e. cash. Only long term assets were available such as loans. This meant that if a bank had loaned £500,000 as a mortgage backed security to a homeowner, the bank was unable to ask for that money back until the maturity date which tends to be very long. Liquidity crisis became very apparent in 2007 and as prior to 2007 banks saw short term lending less profitable and long term lending such as mortgages highly profitable. And when the financial crisis hit money markets absorbed up and many banks did not have access to sufficient cash which had a huge effect on consumers causing a panic and a ‘run on the banks,’ this gave consumers the understanding that banks were unable to meets it financial commitments. As this happened, around the world central banks were injecting short term liquidity into banks hoping faith and confidence is restored within the banking industry.
The intervention from
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