Monday, 6 April 2015

How Liquidity Drives The US Stock Market

By Dr Frank Shostak

In a market economy a major service that money provides is that of the medium of exchange. Producers exchange their goods for money and then exchange money for other goods.

As production of goods and services increases this results in a greater demand for the services of the medium of exchange (the service that money provides).

Conversely, as economic activity slows down the demand for the services of money follows suit.

The demand for the services of the medium of exchange is also affected by changes in prices. An increase in the prices of goods and services leads to an increase in the demand for the medium of exchange.

People now demand more money to facilitate more expensive goods and services. A fall in the prices of goods and services results in a decline in the demand for the medium of exchange.

Now, take the example where an increase in the supply of money for a given state of economic activity has taken place. Since there wasn’t any change in the demand for the services of the medium of exchange this means that people now have a surplus of money or an increase in monetary liquidity.

Obviously no individual wants to hold more money than is required. An individual can get rid of surplus cash by exchanging the money for goods.

All the individuals as a group however cannot get rid of the surplus of money just like that. They can only shift money from one individual to another individual.

The mechanism that generates the elimination of the surplus of cash is the increase in the prices of goods. Once individuals start to employ the surplus cash in acquiring goods this pushes prices higher.