Short Essay on the Liquidity Approach of Money

The liquidity approach emphasizes the function of money as a store of money. It implies that money is not qualitatively different from other assets. Liquidity is the property of all assets; only the degree of liquidity varies.

The liquidity approach includes in the measurement of money those assets that are highly liquid, i.e., those assets that can be converted into money quickly.

In other words, any asset for which no nominal capital gain or loss is possible qualifies as a perfectly liquid asset and is therefore identified as money.

Those assets for which only slight capital gains or losses are possible are highly liquid and are called near-money assets. Liquidity of an asset depends upon two factors: existence of secondary market and the maturity period of the asset,

(a) The liquidity of an asset is increased by the existence of organised secondary markets,

(b) Shorter the term to maturity of the assets, greater the liquidity. Money has no term to maturity, therefore it is perfectly liquid.

Inclusion of near-money assets in the definition of money makes it empirically more realistic and enables it to explain the actual economic changes in a better way. Measures of money based on the liquidity approach are highly correlated with economic activity.

Economic activity or the level of aggregate expenditure in the country is more a function of overall liquidity rather than of total money stock (i.e., currency and demand deposits).

The prevalence of near-money assets greatly increases the overall level of liquidity and hence the level of economic activity.

An increase in the money supply by the monetary authority leads to an.increase in the liquidity with the public. This increase in liquidity will cause further portfolio adjustments.

The public may be inclined to purchase assets that are less liquid if it purchases financial assets (securities, bonds, etc.), it will cause market interest rates to fall. This in turn leads to an increase in investment.

If it purchases non-financial assets (commodities), the spending will increase directly. In case, national income, output, employment and the price level are potentially increased.

Though the liquidity approach provides a broader and better measure of money supply, its adoption in the actual world is difficult due to following reasons:

(i) If money is theoretically defined to mean anything that serves the liquid-store-of money function, then money will include all medium of exchange assets and ‘more’. This would be a broader definition of money.

But, the empirical difficulties with this definition are: (a) where the list of measures of money will stop and (b) how to quantify the liquidity content of a medium.

(ii) Though the liquidity approach is superior to the transactions approach, but the actual definition of money must take into consideration the empirical realities, the institutional framework of the economy and the availability of data.

(iii) Certain problems relating to the concept of liquidity creates further difficulties in adopting the liquidity approach: (a) It is not easy to quantify the liquidity content of an asset; (b) Liquidity contents of an asset may not be constant.

(iv) Since the central bank does not have much control over the lending activities of the non-bank financial institutions, the existence and growth of near-money assets may create problems in the effective implementation of the monetary policy.