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April 26, 2018 

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FICA: The abbreviation for Federal Insurance Contributions Act, passed in 1939, which established payroll deductions from wage-earning employees and the employers for the Social Security system. This is the noted Social Security tax that wage earners pay and which is then used to provide Social Security benefits to the elderly, disable, and qualified dependents.

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LIQUIDITY:

The ease with which an asset can be converted to money with little or no loss of value. Money, currency and checkable deposits, is the benchmark for liquidity. Money is what other assets are converted to. Different assets have differing degrees of liquidity. Financial assets have differing degrees of liquidity but tend to be more liquid that physical assets. Liquidity is important to components of the three monetary aggregates tracked and reported by the Federal Reserve System--M1, M2, and M3.
Liquidity is degree to which an asset can be converted to money. In general, liquidity can be thought of as how "fluid" an asset is relative to money. Does an asset flow easily into money? If so, then it is highly liquid.

Money: The Benchmark

Liquidity is the ease of converting assets to money. This makes money the benchmark for liquidity. Money has perfect liquidity. Money is placed at the topic of the liquidity designation because it is the most flexible asset available. As THE medium of exchange for an economy, money can be used to purchase or acquire any commodity, any good or service, available.

If a typical rich guy consumer, like Winston Smythe Kennsington III, heads to the market in search of food products, without knowing what specific items he wants to buy, then he is well advised to bring along a little money. He can easily exchange his money for the food that best tickles his fancy. Should he bring his wealth in another form, such as a satchel of stock certificates or a duffle bag of diamonds, then he would be hard pressed to purchase the desired food products.

In fact, once at the market Winston could instead decide to buy the market itself rather than just a few food items... if he has his wealth in the form of money rather than another asset. Trading his satchel of stock certificates or a duffle bag of diamonds for the market might prove more difficult.

Foregone Return

The liquidity benefit of money is purchasing power--the ability to undertake exchanges. The downside, however, is foregone return. This lost return might be in the form of a monetary return (interest payment, profit, stock dividend, etc.) or satisfaction generated from consuming goods.

If Winston heads to the market with a briefcase of currency obtain from "cashing in" a satchel of stock certificates, then he foregoes any dividend or other return that might be had from retaining possession of the stock certificates. If Winston should decide to keep a portion of his wealth in money rather than bags of chocolate-covered peanuts, then he foregoes any satisfaction that might be had the consuming these tasty treats.

As a general rule, an inverse relation exists between liquidity and return. An asset that has relatively greater liquidity tends to generate less return. Moreover, an asset that has a greater return usually has less liquidity. In particular, as THE benchmark for liquidity, money generates less return than almost any other financial asset available.

Easing the Flow

Assets tend to be more liquid if they are generally valued by members of society and if cost of transferring ownership is minimal.
  • Robust Markets: Assets that are widely valued by society, especially those that have established, robust, active markets, tend to have greater liquidity. Money is the benchmark for liquidity because it is deemed valuable by virtually every member of society. Purple porcupine quills are less liquid because they are not deemed valuable by the vast majority of the population. With established, active markets buyers are willing to trade money for the asset.

  • Low Transaction Cost: Assets that are easily transferred from one owner to another also tend to be more liquid. Those assets than incur a substantial transaction cost when exchanged are not very liquid. Transaction cost reduces the amount of money obtained when an asset is "cashed in." Savings deposits at banks tend to have high liquidity because the transaction cost incurred when converting to money is close to nothing. Housing tends to have low liquidity because brokerage fees, closing costs, and other assorted expenses reduce the amount of money generated by the sale.

Financial versus Physical

As a general rule financial assets tend to have greater liquidity than physical assets.

Financial assets, including bank accounts, stock certificates, government securities, and other legal claims, tend to be relatively liquid. This results, in part, because most have active, established markets and transaction cost is low relative to the value of the asset.

In other words, Alicia Hyfield can withdraw $50 of cash from her savings account little effort or expense. And Winston Smythe Kennsington III is bound to find a buying willing to pay the going market price for a thousand shares of OmniConglomerate, Inc. stock should he decide to sell.

Physical assets, including real estate, housing, durable consumer goods, and capital equipment, tend to have relatively less liquidity. Markets that exist for these goods are usually less active and transaction cost tends to be greater. Because physical assets are often more specialized, better suited for some uses than others, finding THE specific buyer wanting the asset and willing to pay the "going market price" is more difficult.

A darling three-bedroom split-level house on a corner lot near shopping and school remains unsold until a buyer who wants a three-bedroom split-level house on a corner lot near shopping and school can be found. Months or even years might pass before such a buyer is found. And then, the cost of transferring ownership to the new buyer reduces the amount of money the seller obtains from liquidating this asset.

Consider the relatively liquidity for this short list of financial and physical assets.

  • Money is the benchmark for liquidity. Money has, by definition, perfect liquidity. It can easily and quickly be transferred into itself.

  • Bank accounts are very liquid. Savings deposits have just a touch less liquidity than money. A quick stop by an ATM machine can easily turn savings into cash. The conversion is quick and simple, with little or no transaction cost.

  • Other financial assets are relatively liquid, but another notch down from bank accounts. Stocks and bonds, such as what Winston Smythe Kennsington III might own as a big-time investor, have a great deal of liquidity. Brokerage fees and other transactions costs reduce the value of these assets when converted to money, but not a lot.

  • Physical assets tend to have varying degrees of liquidity. In some locations, real estate can be converted to money with little or no loss of value, if the "market is strong." In other locations, where the "market is weak," the conversion can be timely and costly.

  • Other physical assets, such as automobiles, have a modest degree of liquidity, once again, depending on the particular car and the amount of activity in the market.

  • A host of physical assets, especially consumer durable goods, have very little liquidity. Converting furniture to money is a daunting task. Finding buyers for small kitchen appliances is almost impossible.

Monetary Aggregates

Liquidity plays a key role in the three monetary aggregates tracked by the Federal Reserve System--M1, M2, and M3. M1 is currency and checkable deposits. It IS money and thus has perfect liquidity. The other two monetary aggregates are calculated by progressively including less liquid near monies.

M2 is the sum of M1 and four very liquid, but not perfectly so, near monies--savings deposits, money market deposits, certificates of deposit, and money market mutual funds. Each of these financial assets can be quickly and easily converted to either currency or checkable deposits with almost no loss of value. If money has a liquidity of 100 percent, then most of these financial assets are in the 99 percent liquidity range.

M3 is the sum of M2 plus for slightly less liquid near monies--institutional money market mutual funds, large denomination certificates of deposit, repurchase agreements, and Eurodollars. Each of these assets can be converted to money, but the process is a little more involved than simply paying a visit to the corner ATM machine. These financial assets are probably in the 95 to 98 percent range.

While the liquidity of the near monies in M3 are less than those in M2 which are less than the currency and checkable deposits in M1, all of the components of these monetary aggregates are more liquid that other financial assets (commercial paper, government securities, or corporate stocks) and substantially more liquid than physical assets (housing, real estate, automobiles, or small kitchen appliances).

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Recommended Citation:

LIQUIDITY, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2018. [Accessed: April 26, 2018].


Check Out These Related Terms...

     | monetary aggregates | M1 | M2 | M3 | L | near monies | currency | checkable deposits | value in use | value in exchange | barter | barter exchange |


Or For A Little Background...

     | money | money functions | money characteristics | market | exchange | value | satisfaction | capital | opportunity cost |


And For Further Study...

     | money creation | fractional-reserve banking | banking | Federal Reserve System | monetary economics | monetary base | monetary policy | debit card | monetary economics |


Related Websites (Will Open in New Window)...

     | Federal Reserve System | Federal Reserve Education | U.S. Department of the Treasury | The Currency Gallery |


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