Liquidity Effect in Economics

Liquidity effect, in economics, refers broadly to how increases or decreases in the availability of money influence interest rates and consumer spending, as well as investments and price stability. The Federal Reserve, the main body that controls the availability of money in the United States, employs mechanisms such as changes in the amount of money banks keep in reserve and the sale or purchase of Treasury securities to create liquidity effect.

Interest Rates

Interest rates, essentially the cost of borrowing money, rise and fall based on the total amount of available money in the financial system at any given time. If interest rates rise too far because of limited money in the system, for example, it can lead to an economic slowdown. If interest rates fall too far because of money availability, it risks unhealthy levels of inflation. To moderate these two possibilities, the Fed can buy securities to add available money into the system or sell them to remove money from the system with the goal of maintaining moderate interest rates.

Consumer Spending

Rising interest rates that make it more expensive to finance purchases tend to lead consumer purchasing to level off or decline. This can help prevent bubbles -- rapid swells in property or stock prices followed by a massive collapse -- from developing in a given economic sector, such as housing. By contrast, higher liquidity and lower interest rates make it easier to finance purchases. This liquidity effect can help to spur consumer spending and create growth in a recessionary economy. The Fed lowered interest rates following the 2008 crash for the purpose of creating consumer and business spending, although the results were mixed.

Investment

As with consumer spending, business investment often increases or decreases based on interest rates. In principle, low interest rates encourage businesses to invest in infrastructure and hire additional employees because the financing costs less. Additionally, such expansion should coincide with increased consumer demand spurred by the same lower interest rates. As interest rates rise, businesses invest more cautiously because rate increases can signal an impending slowdown in consumer spending. Rising interest rates also serve as a check against unsustainable expansion in business and industry.

Price Stability

Price stability represents a stated goal of the Federal Reserve. In this context, price stability, refers to product and service prices rising over time. The object is for those prices to rise in step with the pace of economic growth. If prices rise faster than the pace of economic growth, it restricts consumers’ ability to buy some products and economic growth slows. If prices rise slower than the rate of growth, it creates overconsumption that cannot be sustained over the long term.

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