In banking and finance parlance, liquidity refers to the ability to convert one asset into another or to use assets to meet obligations. Liquidity indicates the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. Market liquidity refers to stock market where the assets to be bought and sold at stable prices. The examples of liquid assets are cash and cash equivalents like, stocks, bonds, derivatives or other financial instruments, such as commodity futures contracts, that investors can easily sell for cash.
Aggregate liquidity refers to the ease of execution for financial transactions for everyone in the entire market which is highly dependent on the availability of credit in the markets and the size of the money supply in a country. The following Liquidity aggregates have been formulated for monitoring the state of liquidity in an economy.
L1=M3+Postal Deposits (excluding National Saving Certificate)
L2= L1+Term Money Borrowings, Certificate of Deposits and Term Deposits of Financial Institutions like IDBI, IFCI, Exim Bank, NABARD, SIDBI etc.
L3= L2+ Public Deposit with non-banking financial institutions.
Aggregates liquidity has a major effect on market conditions. For example, if money supply available to borrowers from the market is insignificant or lessening, then businesses will have a tougher time to get finance for new investments and paying debts. This may result in decisions to call in loans or cut costs, both of which can result in further decreases of the money supply. Under such circumstances, the aggregate liquidity constraints affect badly on businesses carrying large amount of illiquid assets like inventories or real estates may even experience bankruptcy if liquidity aggregates further decline. The Central Banks (RBI) need to prevent decline in liquidity aggregates and intervene to ease the money supply in the economy like expanding access to credit, relax other liquidity restraint on spending, failing which it can negatively affect economic growth of the country.
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